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Is the Euro's Fixed Exchange Rate Regime Undermining Cohesion Policy?

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Is the Euro's Fixed Exchange Rate Regime Undermining Cohesion Policy? European Review, page 1 of 25 © 2020 Academia Europaea. This is an Open Access article, distributed under the terms of the Creative Commons Attribution licence (http://creativecommons.org/licenses/by/4.0/), which permits unrestricted re-use, distribution, and reproduction in any medium, provided the original work is properly cited. doi:10.1017/S1062798720001192 Continental Drift: Is the Euro’s Fixed Exchange Rate Regime Undermining Cohesion Policy? CHRISTOPHER JAMES DAY University of Cambridge, Department of Land Economy, 16–21 Silver Street, Cambridge CB3 9EP, UK. Email: [email protected] The ravages of two world wars and a desire to develop a politically and economically united Europe led to the establishment of the Eurozone in January 1999. The European Monetary Union was a grand experiment that brought 11 European nations under a single currency, the euro. Complexities associated with the imple- mentation of effective fiscal, budgetary and banking coordination left the bloc vul- nerable to asymmetries in the productivity and factor markets of its members. This article analyses how adoption of the euro, which prevented nominal exchange rate adjustments, impacted on the competitiveness and real economies of member states, thereby undermining the European Union’s key priority of creating balanced eco- nomic growth and productivity. 1. Introduction The establishment of the Eurozone in January 1999 marked a significant step towards the European Union’s (EU’s) goal of ‘ever closer union’. Notwithstanding, the absence of sufficient fiscal and budgetary coordination has created tensions between the diverse economies of the European Monetary Union (EMU) (Baldwin and Wyplosz 2012; De Grawe 2012; Stiglitz 2016). These issues adversely impact the EU’s key priority of creating balanced economic growth, com- petitiveness and productivity (Atkinson 2001). The Eurozone’s economic problems have been growing since its inception in 1999 (Arestis and Sawyer 2012; Stiglitz 2016). A failure by policymakers to address asym- metries in productivity across European economies and difficulties in converging real Downloaded from https://www.cambridge.org/core. IP address: 170.106.202.8, on 27 Sep 2021 at 00:06:16, subject to the Cambridge Core terms of use, available at https://www.cambridge.org/core/terms. https://doi.org/10.1017/S1062798720001192 2 Christopher James Day economic factors has led to a gradual divergence in European inflation and compet- itiveness across member states (Arestis and Sawyer 2012). This situation is sub- optimal. Previous literature has examined both the European debt crisis and the degree to which the Eurozone forms an optimum currency area (OCA) (Arestis and Sawyer 2012; Baldwin and Wyplosz 2012; De Grawe 2012). The literature is yet to examine the scale of currency distortions within the EMU and survey how these have impacted on the real economies of Eurozone members. Accordingly, this paper seeks to estimate the extent to with which real exchange rates have deviated from equilibria within constituent states and whether these distortions have had a significant effect on gross domestic product (GDP), unemployment, budget positions and current account balances for individual Eurozone members. This article has a twofold motivation. First, the EU has spent hundreds of billions of euros on ‘cohesion policy’ which seeks to balance European competitiveness and productivity (DG Regio 2017). These efforts are likely to have been undermined by the effect that currency distortions have on an individual nation’s competitiveness. For instance, Eurozone members have experienced asymmetric inflation since the late 1990s (Sinn 2014; Bernanke 2015). In the absence of nominal adjustments, this has had a profound effect on the real exchange rates of EMU members. Consequently, Germany’s level of competitiveness has been abnormally strong, at the expense of peripheral members. This has been reflected in Germany’s record low unemployment, strong economic growth and enormous current account surplus (Eurostat 2017; Bohme 2018; Sachgau and Skolimowski 2018). Second, the absence of fiscal integration within the Eurozone fails to conform to OCA theory. Without a large central budget, the EU is unable to make substantial fiscal transfers between surplus and deficit nations (Arestis and Sawyer 2012). This is problematic given the reticence of individual nations to provide transfer payments and a tendency for bailout packages to be linked with austerity measures (Arestis and Sawyer 2012; Kitsantonis 2018). These views are valid given the problems asso- ciated with ‘free rider’ members when the burden of fiscal irresponsibility is shared. For example, Germany feels it is carrying the burden of Europe, in turn making it reluctant to provide debt relief to other EMU nations (Reuters 2017). Without proper fiscal integration, peripheral economies can only adjust their competitiveness through prices and wages. This will prolong a painful period of deflation, high unemployment and low productivity for deficit members (Arestis and Sawyer 2012; Eurostat 2018). A failure to address this issue will exacerbate distortions as peripheral economies become even less competitive (Stiglitz 2016). Given the euro’s youthfulness compared with other major currencies, such as the United States dollar, and the dynamic process of OCAs, it is to be expected that the European Monetary Union will have a successful future. Addressing the issues con- sidered in this article will facilitate this outcome. This article makes several contributions to the literature. First, it estimates the magnitude of currency distortions within the EMU, which suggests that a large pro- portion of Germany’s recent economic success may well have come at the cost of Downloaded from https://www.cambridge.org/core. IP address: 170.106.202.8, on 27 Sep 2021 at 00:06:16, subject to the Cambridge Core terms of use, available at https://www.cambridge.org/core/terms. https://doi.org/10.1017/S1062798720001192 Continental Drift 3 fellow Eurozone members. Germany has benefited from the euro by amassing a sig- nificant current account surplus. Second, the article demonstrates how these distor- tions have manifested themselves in the Eurozone’s real economy, thereby undermining the effectiveness of European cohesion policies. These findings have significant policy implications. If Europe is to achieve its goal of balanced competitiveness and productivity, policymakers should work towards greater budgetary integration through agreed mechanisms for fiscal transfers.1 Transfer payments from wealthy members, such as Germany, should be viewed as rebalancing payments which offset the effect of currency distortions on national competitiveness. Notwithstanding, peripheral Eurozone members should continue to make structural reforms designed to improve their competitiveness in order to reduce future reliance on fiscal transfers. Overall, this article supports the literature on OCAs by reinforcing the need for greater fiscal integration within the political union. 2. Theory Development Europe does not completely satisfy the criteria of an OCA, particularly with respect to budgetary union. Instead, emphasis was placed on delivering inflation and interest rate convergence (Arestis and Sawyer 2012). Notwithstanding, a period of economic stability between the mid-1980s and 1992 led to the European Monetary System being hailed as ‘having achieved its goal of stabilizing exchange rates among member states of the EEC (European Economic Community), enabling them to move confi- dently forward to the next step of establishing a common currency’ (Neal 2007, 102). By the early 1990s, worrying signs were emerging as nations seeking to maintain a peg with the Deutschmark suffered as a result of Germany’s tight monetary policy stance. This forced Finland out of the Exchange Rate Mechanism (ERM), after which the Finnish Markka depreciated sharply. Similar tensions were experienced in Spain, Portugal and the UK whose currencies were either devalued or withdrawn from the ERM (Neal 2007). Following withdrawal, the UK’s economy picked up as exports rebounded in response to a fall in the value of the pound. In contrast, France maintained the peg to the detriment of its economy, which was suffering from high unemployment and slow growth. By July 1993, France declared that the situation was untenable. In the run up to the establishment of the EMU, interest rate spreads declined (Baldwin and Wyplosz 2012). This lowered borrowing costs, especially for many peripheral members, in turn stimulating investment, incomes, growth and inflation (Sinn and Koll 2000; ECB 2006; Sinn 2010; De Grawe 2012). Southern European countries benefited from low borrowing costs given the introduction of a fixed exchange rate and commitment from other members to prevent their currency value from depreciating (Neal 2007; James 2012). This led to an unsustainable credit boom used to fund an increase in public sector wages and unemployment benefits rather 1. Alternatively, the EMU could consider a looser monetary union. Downloaded from https://www.cambridge.org/core. IP address: 170.106.202.8, on 27 Sep 2021 at 00:06:16, subject to the Cambridge Core terms of use, available at https://www.cambridge.org/core/terms. https://doi.org/10.1017/S1062798720001192 4 Christopher James Day Figure 1. Eurozone Inflation between 1999 and 2017 (to view this figure in colour please see the online version of this journal). than structural reforms to labour market rigidities (Neal
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